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Rule of 72 & Understanding Compounding Interest

Posted By __Jim__ On 10/11/2005 @ 11:03 am In __General,Investing,Personal Finance__ | __6 Comments__

*Originally published on March 8th, 2005.*

One of the most well known rules of thumb regarding interest rates (really, any rate) is the “Rule of 72.” The Rule of 72 is that you take the interest rate and divide it into 72 (that is divide 72 by the rate) and that’s roughly how many years it will take to double your principal.

3% rate – 72/3 = 24 years

6% rate – 72/6 = 12 years

12% rate = 72/12 = 6 years

Okay, now we’ve set the table for something really magical. You know how they say that the power of “compounding interest” is incredible? Well, every time I was told that I just thought they were crazy, interest is interest and I understand that you keep the appreciation in and so your investment gets more momentum (3% of $13 is more than 3% of $10, obviously!). Well, let’s put that together with our quick calculating rule of thumb….

– You start with 3% and a $1,000 principal. In 24 years, it’s $2,000. In 48 years, it’s $4,000. In 72-some-odd years… a mere $8,000.

– If you do it with 6%, you get $2,000 in 12 years, $4,000 in 24 years, … ultimately $64,000 in 72-ish years.

– Finally, with 12%, you end up with $4,096,000 in 72 (or so) years.

So 12% interest isn’t double 6% when you look into the future, it’s actually significantly more ($4M more!). Also, if you look at the results from the 3% and imagine inflation grows at roughly that rate (which is accurate enough), in 72 years you will need $8 dollars to equal the purchasing power of $1 now, the $4M is actually only worth $504,000 now. But still… compounding interest is pretty sweet.

I’m sure I messed up something in there so please let me know if I have.

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